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Strategies in Addressing Foreign Exchange Risk

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Discuss types of foreign exchange risk and strategies to address them.

The types of risks may be enumerated as follows:-

i) Transaction risk;
ii) Economic risk;
iii) Translation risk.

Hedging transaction risk - the internal techniques:
1) Invoice in home currency;
2) Leading and lagging;
3) Matching
4) Decide to do nothing;

Hedging transaction risk - the external techniques:
a) Forward contracts;
b) Money market hedges;
c) Future contracts;
d) Options;
e) Forex swaps; and
f) Currency swaps.


Hedging transaction risk - the internal techniques;

Invoice home currency: an easy way is that company insists its foreign customer pay in the company's home currency and likewise the company will pay for all for imports in home currency. But it does not eliminate the exchange rate risk. It has simply been passed on to customers. The adverse effect of it is that the customers may not be too happy and start looking for an alternative supplier.

However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier.

Leading and lagging: If an importing company foresees that currency in which the payment is to be made may depreciate it may delay in the payment with the consent of the customer/exporter or by extending the terms of the credit. Conversely if the exporter anticipates the currency is likely to depreciate over a period of time it may try to obtain the payment early by extending a discount.
Here the problem arises in guessing which way the movement of the rate will take place.

Matching: if the company's receipts and payment are due in the same currency and at the same time, it can easily match them against each other. Then there remains the problem of unmatched portion of the total transaction necessitating dealing on the Forex markets. One way to overcome this problem is to have a foreign currency account with a bank.
Decide to do nothing: in such situation the company will win or lose some. Theoretically the gains and losses let off to leave a similar result like that of hedged.

While in the short term the losses may be substantial, the additional advantage may be by way of saving in transaction costs.

Hedging transaction risk - the external techniques:
Forward contracts: The forward market is where a firm can buy and sell a currency, at a fixed future date at a predetermined rate, i.e. the forward rate of exchange. This effectively fixes the future rate.
Money market hedges: Here the company deposits/borrows the foreign currency till the date the actual transaction takes place avoiding the uncertainty of the future exchange rate by making the exchange at today's rate.

Futures contracts - The purpose of the future contract is to fix and exchange rate at some future date depending on the basic risk. The future contracts are traded in hedging instruments of standard size.

Options: An option is a right without imposing any kind of obligation to buy or sell a currency at existing price on a future date. In the event of favorable movement in rates the company may allow the option to lapse to take advantage of favorable movement.
The right is exercised only when there is an adverse movement. The difference between call option and put option is that in the case of former the holder has the right to buy the underlying currency and in the latter the holder has a right to sell the underlying currency.
The options are more expensive than the forward contracts and futures.

Companies use options when the need to cover exposure is over a long period of time extending from six to twelve months.

Forex swaps: In Forex swaps the parties agree to swap equivalent amount of currency for a particular period and then re-swap them at the end of the period at an agreed swap rate. The rate of swap and the amount of currency is agreed in advance by the parties hence called a fixed rate or a fixed rate swap. The objective of the Forex swap is to hedge against Forex risk for longer period than on the forward market. Besides it enables access to capital markets from where it may be very difficult to borrow directly - almost impossible.

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Solution Preview

Foreign exchange is an arrangement by which one currency is converted into another allowing international transactions taking place, eliminating the need of physical transportation of gold. It is a transaction of international money businesses between governments or businesses of different countries.

Foreign exchange risk is a financial risk occurring due to unanticipated changes in the exchange rate between two currencies. The investors and multinational business whom export/import goods and services or investing in foreign countries in the entire global economy are exposed to this risk which may result in huge financial loss or gains.

It has never been easy to conduct business abroad. It involves conclusion of business transaction, ensure obtaining payment, facing risk leading to the revenue loss due to fluctuations on the foreign exchange market after the transaction is completed. A minor fluctuation in the value of currency relating to the dollar can cause substantial loss in terms of dollars depending on the volume of the transaction.

This fluctuation may have resulted in gain if the dollar had fallen relative to the foreign currency. But then the managers have to be on their toes to keep a sharp eye on the foreign exchange market. Then if the trading partner is in a country where it is difficult to keep a track of the currency it results in greater problem.

The foreign exchange market is very unstable one now than in the past compelling the companies dealing in the market more prudent and have to evolve strategies to manage the risks involved and hedge against the fluctuations.

It is dependent on the point that which party will bear the risk and further on the various bargaining positions.
Now the types of risks may be enumerated as follows:-

i) Transaction risk;
ii) Economic risk;
iii) Translation risk.

Hedging transaction risk - the internal techniques:
1) Invoice in home currency;
2) Leading and lagging;
3) Matching
4) Decide to do nothing;

Hedging transaction risk - the external techniques:
a) Forward contracts;
b) Money market hedges;
c) Future contracts;
d) Options;
e) Forex swaps; and
f) Currency swaps.

A) Transaction risk: It happens when contractual cash flows - receivables and payable that are subject to unanticipated fluctuation in exchange rates as the transaction has been conducted in a foreign currency. The firms ...

Solution Summary

International businesses as well as government of different countries are continually doing business with each other. That involves payment in their respective currencies. That gives rise to “Foreign Exchange". The value of currency of different countries is measured in terms of a medium currency and that is US dollars. What is the value of currency of one country in terms of US Dollars decides how much the transacting parties are liable to pay each other.

The transacting parties evolve various strategies to minimize their losses in making or receiving of payments from each other. Finally the payment or the receipts have to be made in an international currency that is US dollars. If the value of the currency of importing country is more than the US D than the exporting country it will buy dollars at a cheaper rate and vice-versa.

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A) Foreign economies are stronger than the U.S. economy.
B) Foreign stocks are less risky than the stocks of U.S. corporations.
C) Stock dividends received by foreign companies are not subject to US taxes for US citizens.
D) Returns on foreign company stocks do not always change in the same direction as returns on U.S. stocks.

What is an advantage of using ratio analysis in comparing financial statements from different countries?

A) Ratios are expressed as percentages, making currency differences irrelevant to the analysis.
B) Ratios highlight the holding gains or losses related to currency translation.
C) Purchasing power gains and losses from currency translation show up clearly in ratio analysis.
D) Comparing business ratios across countries removes the effect of economic conditions and business culture.

In order to appropriately analyze the trends in foreign financial statement data, which exchange rates should be used?

A) historical exchange rates
B) beginning of year exchange rates
C) current exchange rates
D) average exchange rates

What is a plan for next year expressed in quantitative terms?

A) strategy
B) capital budget
C) operating budget
D) management control system

The process of identifying, evaluating, and selecting projects that require substantial amounts of resources and are expected to generate benefits for many years into the future is called:

A) strategy formulation.
B) strategic planning.
C) capital budgeting.
D) operational budgeting.

The possibility of loss due to unexpected changes in currency values or interest rates is called:

A) economic risk
B) financial risk
C) business risk
D) political risk

Which of the following should not be included in implementing performance evaluation systems?

A) Feedback and review
B) Fair and achievable measures
C) Understandability
D) Changing systems quarterly

What group is responsible for developing international auditing standards?

B) IOSCO online

The MOU signed by the FASB and IASB in 2002 is known as the

A) Convergence Agreement
B) Norwalk Agreement
C) Norfolk Agreement
D) US GAAP/IFRS Agreement

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